Monday, June 23, 2008

How much would a change in ethanol policy affect corn prices?

Here is the story from one of the most authoritative sources in agricultural economics, the Center for Agricultural and Rural Development at Iowa State University.

In a working paper (.pdf) released this month, Lihong Lu McPhail and Bruce Babcock consider the impact of three policy changes: (1) removing the Renewable Fuel Standards, which mandate that a certain fraction of fuel comes from ethanol, (2) removing the blenders tax credit, a direct tax subsidy to blenders, and (3) removing the tariff on imported ethanol, which encourages the conversion of U.S. corn to ethanol by keeping domestic ethanol prices high.

They reach the following conclusion about short term effects:

Eliminating any one of the policies would reduce average corn prices by less than 4%. Removal of all three programs would decrease average corn prices by 14.5%. The reason why the changes are relatively modest is that existing U.S. ethanol plants will only shut down if their variable cost of production is not covered. Changes in ethanol policies would have large distributional impacts. Corn growers, ethanol producers, and fuel consumers have a large incentive to maintain high ethanol consumption. Gasoline producers have a large incentive to reduce ethanol production and imports. Livestock producers have a large short-run incentive to reduce domestic ethanol production.

The authors plan future work to consider the corn and soybean markets jointly, and to lengthen the time period focus.

I would add that 14.5% seems like too big a price reduction to dismiss lightly. Also, the authors explain that ethanol plants will keep operating even if they are failing to pay for themselves, so long as their sales cover at least their variable costs (such as purchases of inputs). But, the investments in the plants themselves were in many cases also subsidized by the federal government, so the impact of federal policies has almost certainly been to raise corn prices by more than 14.5%, and in the midst of an unusual price spike to boot.

For further reading, the Environmental Working Group has just released a blistering report on ethanol policies (see coverage at Mulch).